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How can we create better pension systems?

When a gentleman appears at the doorstep of a house in Cape Cod on a warm day in early spring looking for a summer rental, it might be that he’s only interested in a rental. It might also be that the gentleman is an economist in the middle of an in-depth experiment, attempting to understand the search process in a rental market. Or, it might be Peter Diamond doing both things at once, a combination that would lay the foundation for his Nobel Prize winning work decades later in 2010.

At a glance

Modes of distraction: Took up juggling when struggling to find a research question for his dissertation

Family issues: Is possibly the only Nobel laureate whose family heard the good news before he did

Outside the box: Took classes at Harvard Law School to find new research ideas

Way with his students: "I don’t give advice. The cutting edge belongs with young people."

Research with impact

This Nobel laureate’s research contributions are numerous and extend far beyond economics. To name just a couple: Diamond’s work on optimal taxation with James Mirrlees (the Nobel Laureate in 1996) jumpstarted the field of public economics. In the field of policy-making, his investigation of pensions helped to reform the US system, and moreover, helped to design the Polish pension system from scratch.

A realistic approach to economic markets

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The importance of bringing economics and politics together

"For me, policy and basic research have a very strong back and forth," says Diamond in his sunlit office at MIT, his Alma Mater and employer since 1966. "I was looking at basic research as information input into policy analysis. I then used policy analysis to identify questions that would have really interesting answers. Research is about not just answering a question, but answering questions that are truly interesting and useful."

Diamond’s methods for understanding socioeconomic processes have set him apart from other theoretical economists. After mulling over a question, Diamond generates an array of ideas for modeling the problem and finding solutions. But he doesn’t stop there, because what drives him is the issue’s practical relevance. No wonder his former colleague at MIT and friend Nobel Laureate Eric Maskin calls Diamond an 'application-oriented theorist'.

When I work on a new piece of theory, I often begin by finding a concrete example I want to explore. And then I look for a way of thinking about it that has a chance of being more general, more broadly applicable.

The challenge of a lifetime: pension systems

Expanding your horizon by going to law school

Economic modeling is merely an instrument to help find solutions: theoretical models aren’t a solution in themselves, nor do they imply practical applicability. He takes issue with academia in general by saying: "Too much of the profession tends to take models literally, rather than saying: 'What have I learned from this? How does it affect how I think about this or that?'"

Head of the Department of Economics at MIT and colleague James Poterba says that some of Diamond’s most exciting research has evolved from his teaching. Not only does he aim to grasp the essence of a problem, he wants to get to the core of it and think like an insider. For instance, when the question of how laws and regulations affect economic problems aroused his curiosity, he enrolled in courses at the Harvard Law School. He attended classes and completed the exams like any other student. This in-depth approach allowed him to think about his research problem from a lawyer’s perspective.

What's crucial when creating a sustainable pension system?

Accompanying Diamond to a weekly informal student and faculty lunch meeting shows how much Diamond sees research as a collective activity. In an informal space, students and faculty members regularly mingle and discuss their work over a meal. But when it comes to giving advice, he prefers to take a back seat.

When students come to me and ask for general advice about getting started on a thesis or pursuing a question, I begin by saying: 'I don’t give advice'. I don’t do that because the cutting edge always belongs with young people.

How can a pension system include the young and self-employed?

That’s probably why Diamond has spent a lot of time working on the question of how to create pension systems for all generations. Back in 1972 he was asked to help reform the US social security system. Congress believed it was heading for bankruptcy and that previous reforms had contained serious mistakes. Diamond agrees:

"One of the difficulties in running a pension system is the diversity of experience in the economy," Diamond explains. To create a system that works for everyone, you’ll need to consider people’s very different histories of earning, for example. "A system that’s addressing all of the issues will be worrying about poverty, about high-risk workers and families, too." He emphasizes how important it is to design a system for everyone, but that systems at the same time will always be subject to many different risks.

Who knows how life expectancy will grow, how labor force will grow, how well wages will keep up or rise faster than inflation?

What makes a good pension system?

Putting theories into practice

Academics commonly live somewhat nomadic lifestyles: a job can take them to far away, exotic places. Peter Diamond and his wife Kate Myrick got their taste of academic wandering during his sabbatical years in Nairobi, Tel Aviv, and Cambridge. Since then, they chose to settle in the Boston area and now call it home. "Home is where I want to come back to, where I unwind and connect, not just with family but with my sense of the world, because then I can step back and think about things," he says.

Having a strong connection to the home and family helped Diamond excel in academics and policy formations, as well as granting him the opportunity to contribute to the local efforts of his town community. Both Diamond and his wife have been elected to the local authority of the town he lives in. As a public finance economist, Diamond had a good grasp of the basics of local public finances, and he ran a successful campaign to increase tax revenue to meet the town’s budget.

When his re-election for the next term came up, he chose an unorthodox message to appeal to voters in his small constituency: "When I was running for office after my wife was elected, I knew that a win would mean I’d be with her at all the town meetings, several evenings a week. So I said to the voters: if they cared about family values, they should vote for me because that meant I’d get to spend time with my wife, and that’s a very serious family value." The laureate only half-jokes, revealing the admirable ability not to take himself too seriously.

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What does Diamond’s work mean for us?

"Every firm charges the price that a monopolist would charge. This result – the Diamond Search Paradox – is so astonishing that our instinct is that it can’t possibly be true."

Tim HarfordFinancial Times columnist and author of The Undercover Economist

"The idea of search friction applies across a huge range of markets, and it’s something that is extremely important to understanding the modern world. If friction exists, it will affect prices in markets."